oligopoly overheads
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Oligopoly
Overheads
Market StructureMarket structure refers to all characteristics of a marketthat influence the behavior of buyers and sellers,when they come together to trade
Market structure refers to all features of a market that affectthe behavior and performance of firms in that market
Definition of a competitive agent
A buyer or seller (agent) is said to be competitivecompetitive if theagent assumes or believes that the market price is givenand that the agent's actions do not influence the market price
We sometimes say that a competitive agent is a price taker
Common Market Structures
Perfect (pure) competition
Agents take prices as given
Entry and exit barriers are minimal or nonexistent
Common Market Structures
Monopoly (seller) or Monopsony (buyer)
Firm sets price(faces market demand or supply curve)
Entry and exit barriers result in the existence ofone seller or one buyer
Common Market Structures
Oligopoly
Firm sets prices (faces residual demand)
Entry and exit barriers result in the existence offew sellers or buyers
Common Market Structures
Monopolistic competition
Firm sets prices (faces residual demand)
Entry and exit barriers are minimal
Strategic interdependence
When individuals make decisions in environmentscharacterized by strategic interdependence,the welfare of each decision maker depends not onlyon her own actions, but also on the actions ofthe other decision makers (firms).
Moreover, the actions that are best for her to takemay depend on what she expects the other firms to do
Formal definition of oligopolyNoncooperative oligopoly is a market structurewhere a small number of firms act independently,but are aware of each other's actions
A noncooperative oligopoly is a market structurein which a small number of firms arestrategically interdependent
Cooperative oligopoly is a market structurein which a small number of firms coordinatetheir actions to maximize joint profits
Oligopoly is an intermediate market structure in thesense that the firms are price makers as comparedto the price takers of perfect competition,but because there are others firms in the market,the firm cannot act in the independent fashionof the monopolist
A duopoly is a market with only two firms,each selling the same or similar product
Duopoly
Two firms with no additional entry
A Duopoly Model
Each firm produces a homogeneous product suchthat q1 + q2 = Q, where Q is industry outputand qi is the output of the ith firm
There is a single period of production & sales (zucchini)
The market demand and inverse demand are linear
Q q1 q2 14 12p
Demand
p 28 2Q 28 2q1 2q2
Cost (q1) 4q1
Cost (q2) 4q2
MC1 AC1 4
MC2 AC2 4
Marginal and average cost are constantand equal to $4.00
Monopoly solutionFirm 1 is the only firm in the market
Revenue is given by
Revenue (q1) pq1
(28 2q1) q1
28q1 2q 21
Using the same intercept, twice the slope rule,marginal revenue is given by
MR (q1) 28 4q1
If we set marginal revenue equal to marginal costwe can obtain the optimal level of q1
MR (q1) 28 4q1 4 MC (q1)
24 4q1
6 q1
If we substitute this into the demand equationwe can find the market price
p 28 2q1
28 (2)(6) 16
Profit for Firm 1 is given by revenue minus cost or
Profit π R C pq1 c (q1 )
(16)(6) (4)(6) 96 24 72
Zucchini MarketMonopoly
05
1015202530
0 2 4 6 8 10 12 14 16
Quantity
$ Demand/P
MC
MR
Q Price TR MR Cost MC Profit0.00 28.00 0.00 28.00 0.00 4.00 0.00
1.00 26.00 26.00 24.00 4.00 4.00 22.002.00 24.00 48.00 20.00 8.00 4.00 40.00 2.50 23.00 57.50 18.00 10.00 4.00 47.50
3.00 22.00 66.00 16.00 12.00 4.00 54.003.50 21.00 73.50 14.00 14.00 4.00 59.504.00 20.00 80.00 12.00 16.00 4.00 64.004.50 19.00 85.50 10.00 18.00 4.00 67.505.00 18.00 90.00 8.00 20.00 4.00 70.005.50 17.00 93.50 6.00 22.00 4.00 71.506.00 16.00 96.00 4.00 24.00 4.00 72.00 7.00 14.00 98.00 0.00 28.00 4.00 70.008.00 12.00 96.00 32.00 4.00 64.009.00 10.00 90.00 36.00 4.00 54.0010.00 8.00 80.00 40.00 4.00 40.0011.00 6.00 66.00 44.00 4.00 22.0012.00 4.00 48.00 48.00 4.00 0.00 13.00 2.00 26.00 52.00 4.00 -26.00
Competitive Solution
We set price (p) equal to marginal cost (MC)
MC 4 p
Notice that MC doesn’t depend on qi or Q
Q q1 q2 14 12p
If we substitute p = 4 in the demand equation we obtain
14 12
(4)
14 2 12
Profits will be zero
Zucchini MarketCompetition
05
1015202530
0 2 4 6 8 10 12 14 16Quantity
$ Demand/P
MC
If the two firms in this market were to coordinatetheir actions and maximize joint profit,
Cooperative (collusive) oligopoly solution
they would choose the monopoly output and price
Such cooperative agreements are called cartels
The two firms together would produce 6 unitsand charge a price of $16.00
The division of the output between the firmswould have to negotiated between them
Noncooperative Oligopoly
Joint profits maximized with Q = 6 and p = $16
Will this outcome occur?
Individual firm conjectures and market equilibrium
Conjecture
A supposition or guess
Each firm makes a conjecture about the actionof the other firm and then chooses its own action
Story
Firm 1 conjectures that Firm 2 will produce 3 units
Why?
Inverse demand given the conjecture
p 28 2q1 2q2
28 2q1 (2)(3)
22 2q1
Revenue for Firm 1 given the conjecture
Revenue (q1 , q2) pq1
(22 2q1) q1
22q1 2q 21
MR (q1) 22 4q1
Marginal revenue is given by
because
p 22 2q1
If we set marginal revenue equal to marginal costwe can obtain the optimal level of q1
MR (q1) 22 4q1 4 MC (q1)
18 4q1
4.5 q1
If Firm 2 produced 3 units, price would be
p 28 2q1 2q2
28 (2)(4.5) (2)(3) 28 9 6 13
Profit for Firm 1 is given by revenue minus cost or
Profit π R C pq1 c (q1 )
(13)(4.5) (4)(4.5) 58.5 18 40.5
Profit for Firm 2 is given by
Profit pq2 c (q2 )
(13)(3) (4)(3) 39 12 27
Total profit for the two firms is $67.50
Monopoly profit was $72
Is Firm 2 happy?
Is Firm 2 content?
Is Firm 2 going to keep producing 3 units?
Let’s See
Suppose Firm 2 conjectures thatFirm 1 will produce 4.5 units
Inverse demand given the conjecture
p 28 2q1 2q2
28 2(4.5) (2)q2
19 2q2
MR (q2) 19 4q2
Marginal revenue is given by
because
p 19 2q2
If we set marginal revenue equal to marginal costwe can obtain the optimal level of q2
MR (q2) 19 4q2 4 MC (q2)
15 4q2
3.75 q2
If Firm 1 produces 4.5 units and Firm 2produces 3.75 units, price will be
p 28 2q1 2q2
28 (2)(4.5) (2)(3.75) 28 9 7.5 11.5
Profit for Firm 1 is given by
Profit pq1 c (q1 )
(11.5)(4.5) (4)(4.5) 51.75 18 33.75
Profit for Firm 2 is given by
Profit pq2 c (q2 )
(11.5)(3.75) (4)(3.75) (7.5)(3.75) 28.125
Total profit for the two firms is $61.875
Monopoly profit was $72
Because Firm 2 is producing 3.75 and not 3 units
Firm 1 will want to adjust its output level
And then Firm 2 will want to change its output
This silly game could go on forever
We can compute the best response for each firmgiven the action of the other firm to see this
Other q q1* q2
3.00 4.500 4.5003.25 4.375 4.3753.50 4.250 4.2503.75 4.125 4.1254.00 4.000 4.0004.25 3.875 3.8754.50 3.750 3.7504.75 3.625 3.6255.00 3.500 3.500
What if Firm 1 conjectures thatFirm 2 will bring 4 units to market?
Firm 1 will bring 4 units to market!
Other q q1* q2
3.75 4.125 4.1254.00 4.000 4.0004.25 3.875 3.8754.50 3.750 3.750
What if Firm 2 conjectures thatFirm 1 will bring 4 units to market?
Firm 2 will bring 4 units to market!
Other q q1* q2
3.75 4.125 4.1254.00 4.000 4.0004.25 3.875 3.8754.50 3.750 3.750
Both firms are happy and content
We have an equilibrium!!
0
2
4
6
8
10
12
14
0 2 4 6 8 10 12 14 16
q2
q1
Zucchini MarketResponse Functions
q1*
q2*
Graphically
A situation in which all economic actors (firms)interacting with one another choose theirbest strategy, given the strategies that all other actorshave chosen, is called a Nash Equilibrium
A market outcome is a Nash Equilibrium if no firmwould find it beneficial to deviate from its output levelprovided that all other firms do not deviate from theiroutput levels at this market outcome
The market outcome of this noncooperativeoligopoly market is an output of 8 unitswith a price of $12.00.
The output is lower than the competitiveoutput but higher than the monopoly output
The price is lower than the monopoly pricebut higher than the competitive one
This is a result that holds generally
Monopoly 6 6 -- 16 $72 $72 --Perfect Competition 12 ? ? 4 $0 $0 $0Cooperative Oligopoly 6 ? ? 16 $72 ? ?Noncooperative Oligopoly 8 4 4 12 $64 $32 $32
Total Firm 1 Firm 2 P Total Firm 1 Firm 2 Q q q
Results
Oligopoly and the number of firms
Small number of firms large price impact of individual
Larger number of firms less price impact
As the number of firms in an oligopoly rises,the impact of any one firm on price falls
As numbers keep getting larger, firms start to actmore and more like price takers
The End
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